Why JP Morgan Lost a Bundle… And Why Really Smart People Can Destroy the World

[Warning: This blog is 1,800 words, and hard to read. Read it ONLY if you really want to understand why JP Morgan Chase lost $2 b. and has rattled the whole world. If you wish, skip to the last three paragraphs, which capture the essence.]

John Pierpoint Morgan

Last Thursday night, Jamie Dimon, the respected CEO of America’s largest bank, J.P. Morgan Chase, made a staggering announcement. He reported to the media that his bank had lost $2 b. in securities trading. Immediately, J P Morgan’s stock price dropped, and stocks fell in general. And old John Pierpoint Morgan is turning in his grave.

J P Morgan Chase has over $2 trillion in assets. So a tiny $2 b. loss is only 0.1 per cent, or 1/1000 of its assets. Did the capital markets over-react? Not at all. J P Morgan is widely respected for its risk management, and it weathered the global financial crisis 2007-11 better than other banks. If J P Morgan is in trouble, if it takes big uncalculated risks, well, in whom can we trust?

WHAT IN THE WORLD HAPPENED?

According to the respect New York Times column and blog DealBook, in early April there were rumors about JP Morgan’s Chief Investment Office. [Background: JP Morgan Chase has been profitable, despite the bleak capital markets, largely due to this office. The Office is really a kind of hedge fund, making investments in anything and everything and reducing the resulting risk by spreading the investments widely. Some of these investments were ironically in credit default insurance – a complex asset whose riskiness is hard to measure, and which in large measure led to the onset of the global crisis in 2007-8.]

The rumors said a JP Morgan trader called The London Whale was making huge bets on derivatives, big enough to distort the whole market. When the Fed began to investigate, JP Morgan CEO Jamie Dimon flatly denied the rumors. [How much déjà vu have you seen in this story already – and I’ve barely begun!]. He told analysts the whole thing is a “tempest in a teapot”. Perhaps – but that teapot was pure arsenic.

WHO WAS RESPONSIBLE?

The New York Times names Ina Drew, the bank’s Chief Investment Officer, and the London Whale, named Bruno Iskil, who led the specific trade that lost all that money. Ina Drew fiercely defended the huge trade done by her star trader in London. But JP Morgan executives, from the 48th floor of their Park Avenue headquarters, became increasingly alarmed. A team of risk officers called the Navy Seals began to meet daily on the problem. (The semantics of financial speculation are colorful, because the traders themselves are colorful…e.g., Goldman Sachs called its clients “Muppets”.) The trade was so big, when it began to go bad, it could not be ‘unwound’ (reversed), even by “Navy Seals.” Other hedge funds got wind of the fact that JP Morgan was in trouble, and began betting against it, specifically betting on the opposite side of the huge bet JP Morgan’s hedge fund had taken. This is not unlike a bleeding dolphin in the ocean – sharks smell the blood and attack fiercely. When that happens, well, frankly, you’re dead.

CAN YOU BE MORE SPECIFIC ABOUT ‘WHAT WENT WRONG’?

Here is the clearest explanation I could find, by NYT experts. It’s not easy reading…but it’s worth persisting to the end. I closely follow everything NYT columnist Andrew Sorkin writes.

“In 2009, [JP Morgan’s Chief Investment Office] unit’s net income peaked at $3.7 billion, up from $1.5 billion the previous year. The jump in earnings in 2009 resulted from large purchases of mortgage-backed securities guaranteed by the United States government, according to a company filing. Net income for last year totaled $411 million. Last summer the chief investment office began calling brokers at several Wall Street banks, the brokers say. The office was offering to sell insurance on an index of big American corporations like General Mills, Alcoa and McDonald’s — known as CDX IG Series 9. If the companies in the index went bankrupt, JPMorgan would have to pay out, but if the companies continued to do well JPMorgan could rake in the fees from financial firms that bought the insurance. The strategy initially made money for JPMorgan and its position began to grow, as did an appetite for it among a tight-knit segment of hedge funds focused on credit opportunities. The large scale of the trade was permitted as a result of an expansion in the limits placed on the size and the scope of securities the unit could trade in that were adopted after JPMorgan acquired Washington Mutual in the financial crisis. Those limits have now been scaled back. By January, these hedge funds were getting calls nearly every day from brokers representing the chief investment office, according to hedge fund managers and brokers on the calls. The seller’s identity was not supposed to be known, but the sheer volume of the trade made it hard to hide, and soon enough all fingers in the “small, clubby world” of credit hedge funds pointed to Mr. Iksil’s desk at JPMorgan, according to one fund manager. “A bunch of us started looking at it and talking about it a lot,” the manager said. “There was agreement that Bruno was selling.” There were two ways that JPMorgan could win this bet. 1. If the companies in the index did well, the bank’s cost of insuring the index would continue to fall. 2. JPMorgan could also artificially drive the price lower by continuing to issue more and more insurance — a distinct possibility thanks to JPMorgan’s size and stature. In January and February, as the price of the insurance continued to drop, lunch meetings and casual conversations between hedge fund managers swirled around the ability of JPMorgan to continue financing this bet. “A lot of people told me it was a foolish trade,” said an official with a hedge fund that bet against JPMorgan. “The naysayers on this trade said, ‘Look, this guy has unlimited firepower, he can just keep selling and selling and make your life miserable.’ ” Among the hedge funds that began taking positions against JPMorgan were Blue Mountain, a New York fund; Lucidus Capital Partners, a London fund; Hutchin Hill, a New York fund; and Bluecrest, a giant London hedge fund founded by two former traders on JPMorgan’s proprietary trading desk. The trade did not at first make money for the hedge funds betting against it. In the improving economy early in the year, the hedge funds had to make regular insurance payments. But in late March, doubts about the economy began to swirl, and the index jumped. JPMorgan began seeing losses by the end of the first quarter, on March 31, but they were not enormous, allowing bank executives to shrug off the early criticisms of the trade. But the trade drew increasing attention as the index continued to spike, multiplying JPMorgan’s potential losses if it had to pay out on the insurance. Soon United States and British regulators were talking daily with bank executives. (The New York Fed has been following the chief investment office practically since its inception, as part of its regular supervision of the firm.) [But despite ‘following’ the problem, the Fed did nothing, nor could it do anything – until it was too late].

WHY ARE CAPITAL MARKETS SO UPSET?

Because this should not, could not possibly, have happened. Because it was precisely trades like this one that got Bank of America, Lehman Brothers, Citigroup and others in such hot water. And because few even knew about the existence of the business unit of JP Morgan that caused the problem. Another instance of under-the-radar risk that we discover only when it blows up.

Morgan’s Chief Investment Office “ employs fewer than 40 people across the bank’s international offices, and was created to manage the bank’s exposure to complicated global financial transactions, like interest rate changes and currency movements.” Unlike JPMorgan’s deal-making investment banking unit, the chief investment office was supposed to keep its head down, carrying out trades that protected the bank from the volatility caused by the recent financial crisis. Yet what began as a way to hedge against risk has turned into a major liability.”

HOW DID THIS ALL START?

“In 2007, the bank hired Achilles Macris of Greece. He was charged with running the unit’s European operations on the sixth floor of JPMorgan’s offices near St. Paul’s Cathedral in London’s financial district. As part of an expansion, Mr. Macris turned to a number of former hedge fund and investment banking experts to bulk up the European team. Under the leadership of Mr. Macris in London and Ms. Drew in New York, the group’s exposure to financial markets ballooned. Ms. Drew — one of the highest-ranking women and one of the highest-paid executives at the bank, making $15.5 million last year — is widely viewed as a natural trader with an eye for unusual opportunities to strike a profit.”

SO HOW DID SUCH BRILLIANT PEOPLE GO WRONG?

It’s the fundamental problem with banking today. When you’re paid $15.5 m., well, you better bring big bucks to your employer and to your shareholders. You’d better perform. The only way to make money is to take risks. And it is perpetually tempting to take excessive risks. Why? Well, because, people who are paid $15.5 m. yearly are really really REALLY smart. For them, they are not taking risks, because, well, they KNOW which way the market is going. How do they know they know? Because they guessed right in the past – otherwise, why would they be paid $15.5 m. every year? It’s an accident waiting to happen.

WHAT IS THE SOLUTION?

It is so obvious. Restore a much much tougher Volcker Law. Paul Volcker was the respected head of the American Fed under Ronald Reagan, in the 1980’s. After the recent global crisis, Volcker recommended banning banks from the kind of speculative trading that got them into trouble, including J P Morgan. But the Republicans managed to remove the teeth from the law, and the current version, even if fully enacted, would not have kept J P Morgan from the kind of ‘hedging’ that got it into trouble. What we need is a simple law, with one line. Banks cannot trade, for their own account, credit derivatives. Period.

WHO IS REALLY TO BLAME?

Chalk another one up to the Republicans. They have prevented effective legislation to force banks to do what banks do, and what the original John Pierpoint Morgan did so well – take deposits and lend money. Old John Pierpoint made a fortune lending wisely at 10 % (including to Thomas Edison to ‘electrify’ America). This indeed was banking to create a good society. Why can’t we return to it?

John Pierpoint Morgan once said, “a man always has two reasons for doing things, a good reason and the REAL reason.” JP Morgan Chase had a good reason for its hedge trading (reduce risk) and a REAL reason (make piles of money, to offset weak performance in conventional banking).

Will we finally get some tough banking regulation laws in America? Don’t count on it.

Laura, why do I insist they’re brilliant? Because, Laura, I know some of them personally. And they simply are. Of course, when things go radically wrong, with hindsight we say, they’re dumb. Do you really believe JP Morgan would pay someone $15.5 m. a year if they weren’t smart and had good track records? The problem is not the smart people, but the system, which encourages excessive risk and plays into the hubris of these people..and allows them free rein for far too long, until the disastrous trades can’t be reversed…. Believe me, genius plus hubris plus free rein is FAR more scary than stupidity…

Great article Shlomo. Best summary of this JP Morgan fiasco I’ve read anywhere. (the $2B loss is probably only the tip of the iceberg). However, I strongly disagree with your assessment that this is the Republicans fault; Both parties are at fault!! Let’s not forget is was Clinton who signed gramm leach act to get this whole party started, or that Obama had close ties with Jon Corzine and had him pegged as his next Treasury Secretary! Under the current system where both parties rely on campaign contributions from these banks and there is a revolving door between Wall Street and Washington both parties have become shills for Wall Street! Blaming one party over another is counterproductive as it distracts from the real problem, which is the current system. A system in which both parties continue to propagate.

Ross, you’re quite right. George Bush made the credit default swap possible by legislation that exempted them from regulation (by letting them be called ‘swaps’ instead of ‘insurance’. But Clinton indeed signed Gramm-Leach. Let’s also blame the economists. No-one really seems to know how to fix the current system. I recommend Bob Shiller’s new book out soon, Finance and the Good Society. He has some good ideas.

I’ll keep an eye out for that book Shlomo. I think a good start in fixing the current system would be to somehow break up these behemoth banks up so they actually could fail without taking down the whole system. I’m sure removing the moral hazard that goes along with these big banks knowing they will be bailed out would certainly sharpen their risk management processes.

Brillant is different than smart. The problem is perspective. Caesar could not see how people saw him. He thought that if his accomplishments were beyond the grasp of his contemporaries, they would in the natural order of things accept him as dictator. The math wizzes at Morgan- Chase cannot understand why they can’t use bank deposits as a foundation for synthetic credit trading. You have none of your own money at risk, and you stand to gain huge returns. It’s a beautiful thing. Then people stop making mortgage payments, and reality dawns. But it still lays out in their equations, gussied-up with all forms of advanced calculus. And it always will. But they have forgotten the sage advice of Joe Frisco. “All hoss players die broke.”

Oh, no, no possible way for dozens of reasons. Lehman Bros. was a disastrous error, never to be repeated. JP Morgan has $1 trillion in assets, and its losses, while they will be more than $2 b., simply put a small dent in its strong profitability. Not to worry… the real worry is that the traders are doing the same thing that caused the previous global crisis in 2008-11….

On the current state of the Volcker Rule: There is a Volcker Rule because it was these derivative positions that caused the global financial crisis. All of the systemically dangerous institutions failed in large part because of these financial derivatives – what we call the green slime . That’s what brought down Fannie and Freddie and Lehman Brothers and Bear Stearns and Washington Mutual, Lehman, Merrill Lynch and Wachovia. After those catastrophic disasters that caused the Great Recession, cost six billion Americans their jobs directly, prevented another five to eight million jobs from being created, helped lead to a global crisis called the Great Recession—after that, the banks still fought to be allowed to do exactly the same kind of derivative trades. And even when the Volcker Rule was adopted, over the banks’ opposition and over the opposition of the Federal Reserve and of Treasury Secretary Timothy Geithner, they gutted the rule—at least the draft rule to implement the Volcker Rule. Unless it is changed, the Volcker Rule will be essentially unenforceable, because the current draft allows financial institutions to simply call their trades “hedges”, even though they operate exactly opposite to the way a hedge would work.